Notice To Members 88-93

SEC Approval of Amendment to Free-Riding Interpretation Concerning Sales to Investment Partnerships and Corporations

Published Date:

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EXECUTIVE SUMMARY

NASD members are advised that the Securities and Exchange Commission (SEC) has approved an amendment to the NASD Board of Governors' "Free-Riding and Withholding" Interpretation that would provide members with an alternative means of complying with the Interpretation for sales of new issues to the accounts of investment partnerships and investment corporations and similar type accounts.

The text of the amendment is attached.

BACKGROUND

The amendment to the NASD Board of Governors' "Free-Riding and Withholding" Interpretation (Interpretation) approved by the Securities and Exchange Commission is intended to provide members with an alternative means of compliance with the existing requirements of the Interpretation in making sales of "hot issue" securities to the accounts of investment partnerships and corporations, including hedge funds, investment clubs, and other similar accounts. Under the heading "Investment Partnerships and Corporations," the Interpretation now provides, with no alternative means of compliance, that members and their associated persons are prohibited from selling securities of a new issue that trades at a premium ("hot issue" securities) to any investment partnership, corporation, or similar account unless "the member receives from such account, prior to the execution of the transaction, the names and business connections of all persons having any beneficial interest in the account." If the information discloses that a restricted person has a beneficial interest in the account, the transaction can be effected only in compliance with the restrictions of the Interpretation.

The Interpretation has been construed strictly by the NASD. It is intended to protect the integrity of the public offering system by ensuring that underwriters make a bona fide public distribution of "hot issue" securities and do not retain those securities for their own benefit or use those securities to favor persons who can direct future business to the firm. Without restricting purchases by investment partnerships, the provisions of the Interpretation could be evaded easily.

Because the existing provision was the exclusive means of compliance, the NASD National Business Conduct Committee (NBCC) and the NASD Board of Governors determined that it would be appropriate to propose an alternative means for members to comply with the Interpretation when selling "hot issue" securities to investment partnerships and similar accounts. Because of concern that members can encounter difficulty in complying with the requirements of the provision (since persons responsible for the management of investment partnerships and similar accounts may be hesitant to release the names of persons holding beneficial interests in such accounts), the NASD proposed in Notice to Members 86-40 (May 23, 1986) that a member or associated person would be presumed to be in compliance with the requirements of the Interpretation's section on investment partnerships either by obtaining the list of actual names pursuant to the existing requirement or by receiving from the account manager specific written representations that none of the beneficial owners are restricted persons.

Following review of comments received, the NBCC concluded that the amendment's reliability would be determined by the time and effort expended by the account manager to understand and properly apply the complex provisions of the Interpretation. As a result, the NBCC determined that it should consider other approaches to provide members with an effective means of ensuring that restricted accounts are not recipients of "hot issue" securities in violation of the Interpretation. The NBCC appointed a subcommittee to consider alternatives to amending the Interpretation, including the May 1986 proposal and subsequent proposed modifications to it, as well as a new proposal to establish a "safe harbor" procedure by requiring a member to obtain an opinion of counsel through the account manager.

Based on the subcommittee's study of alternative proposals, the NBCC and Board of Governors concluded that the original proposal should be rejected as a less effective means of ensuring that members are advised correctly of the restricted status of an account than is offered by an opinion-of-counsel approach, which is the approach contained in the amendment recently approved by the SEC. The NBCC also concluded that an assurance by the account manager may be accurate in many situations, but does not offer as positive an assurance as does the opinion of counsel. In particular, the NBCC also noted that account managers are not directly subject to NASD jurisdiction. In NASD Notice to Members 87-73 (November 4, 1987), the opinion-of-counsel proposal was released for member comment. Following review of the comments, the NBCC and Board concluded that an opinion of counsel has the advantage of building a "safe harbor" procedure with a greater degree of accountability than does a blanket representation of the account manager.

EXPLANATION OF AMENDMENT

The amendment is intended to provide an alternative means for members to comply with the Interpretation when selling "hot issue" securities to investment partnerships and similar accounts. The amendment provides that a member or associated person of a member may not sell "hot issue" securities to the types of accounts specified unless, prior to executing a transaction with the account, the member has obtained a copy of a current opinion from counsel stating that counsel reasonably believes that no person with a beneficial interest in the account is a restricted person under the Interpretation and stating that, in providing such opinion, counsel:

1) has reviewed and is familiar with the Interpretation;
2) has reviewed a current list of all persons with a beneficial interest in the account supplied by the account manager;
3) has reviewed information supplied by the account manager with respect to each person with a beneficial interest in the account, including identity, employment, and any other business connections of such persons; and
4) has requested and reviewed other documents and other pertinent information and made inquiries of the account manager and received responses thereto if counsel determines that such further review and inquiry are necessary and relevant to determine the correct status of such persons under the Interpretation.

As the amendment offers only an alternative means of compliance, members may continue to comply with the current requirements of the Interpretation's section on investment partnerships by obtaining a list of the names and business connections of all persons having a beneficial interest in the account from the account manager in the case of both domestic and foreign accounts. The amendment, however, eliminates the present alternative for foreign investment partnership and foreign investment companies' accounts in countries having secrecy laws that now allow a member to obtain a blanket representation from his account manager that none of the beneficial owners are restricted persons. Thus, foreign investment accounts must in the future provide either a list of the names and business connections of the beneficial owners or an opinion from counsel who is required to be an attorney admitted to practice in the United States.

In addition, the amendment requires members to maintain in their files a copy of the opinion of counsel or a list of names of the beneficial owners for at least three years following the member's last sale of a new issue to that account.

Finally, the amendment requires that, irrespective of which means of compliance a member selects, the list of names or opinion of counsel shall be deemed current only for a period of 18 months after which a new list or a new opinion of counsel must be obtained.1

The amendment is effective on the date of SEC approval (August 29, 1988).

Questions concerning this notice can be directed to the NASD Offrice of General Counsel, at (202) 728-8294 or John F. Mylod, Assistant General Counsel, at (202) 728-8288.

AMENDMENT TO FREE-RIDING INTERPRETATION

(Note: New language is underlined; deleted language is in brackets.)

The section under the heading "Investment Partnerships and Corporations" of the Board of Governors' Interpretation is amended as follows: Investment Partnerships and Corporations

A member may not sell securities of a public offering that trade at a premium in the secondary market whenever such secondary market begins ("hot issue"), to the account of any investment partnership or corporation, domestic or foreign (except companies registered under the Investment Company Act of 1940) including, but not limited to, hedge funds, investment clubs, and other like accounts unless the member complies with either of the following alternatives:

(A) [receives from such account,] prior to the execution of the transaction, the member has received from the account a current list of the names and business connections of all persons having any beneficial interest in the account, and if such information discloses that any person enumerated in paragraphs (1) through (4) hereof has a beneficial interest in such account, any sale of securities to such account must be consistent with the provisions of this Interpretation [; provided, however, that if the disclosure of such information by the account is prohibited by law, then, in such case, the member must receive written assurance from the account that no person enumerated in paragraphs (1) through (4) hereof has a beneficial interest in such account], or
(B) prior to the execution of the transaction, the member has obtained a copy of a current opinion from counsel admitted to practice law before the highest court of any state stating that counsel reasonably believes that no person with a beneficial interest in the account is a restricted person under this Interpretation and stating that, in providing such opinion, counsel:
1) has reviewed and is familiar with this Interpretation;
2) has reviewed a current list of all persons with a beneficial interest in the account supplied by the account manager;
3) has reviewed information supplied by the account manager with respect to each person with a beneficial interest in the account, including the identity, the nature of employment, and any other business connections of such persons; and
4) has requested and reviewed other documents and other pertinent information and made inquiries of the account manager and received responses thereto, if counsel determines that such further review and inquiry are necessary and relevant to determine the correct status of such persons under the Interpretation.
The member shall maintain a copy of the names and business connections of all persons having any beneficial interest in the account or a copy of the current opinion of counsel in its files for at least three years following the member's last sale of a new issue to the account, depending upon which of the above requirements the member elects to follow. For purposes of this section, a list or opinion shall be deemed to be current if it is based upon the status of the account as of a date not more than 18 months prior to the date of the transaction.

The term beneficial interest means not only ownership interests, but every type of direct financial interest of any persons enumerated in paragraphs (1) through (4) hereof in such account, including, without limitation, management fees based on the performance of the account.

1 The SEC in its approval correctly noted that neither the existing compliance procedure nor the opinion of counsel alternative provides a "safe harbor" presumption of compliance if a member has actual knowledge that a restricted person has a beneficial interest in the account. Securities Exchange Act Release No. 26039 (August 29, 1988).